Capital Structure II:

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Capital Structure II

• Limits to the Use of Debt

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Costs of Financial Distress

• Bankruptcy risk versus bankruptcy cost.
• The possibility of bankruptcy has a negative
  effect on the value of the firm.
• However, it is not the risk of bankruptcy itself
  that lowers value.
• Rather it is the costs associated with
  bankruptcy.
• It is the stockholders who bear these costs.

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Description of Bankruptcy Costs

• Direct Costs
• Legal and administrative costs (tend to be a
  small percentage of firm value).
• Indirect Costs
• Impaired ability to conduct business (e.g., lost
  sales)
• Agency Costs
• Selfish strategy 1 Incentive to take large risks
• Selfish strategy 2 Incentive toward
  underinvestment
• Selfish Strategy 3 Milking the property

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Balance Sheet for a Company in Distress

• Assets BV MV Liabilities BV MV
• Cash 200 200 LT bonds 300
• Fixed Asset 400 0 Equity 300
• Total 600 200 Total 600 200
• What happens if the firm is liquidated today?

200
0
The bondholders get 200 the shareholders get
nothing.
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Selfish Strategy 1 Take Large Risks

• The Gamble Probability Payoff
• Win Big 10 1,000
• Lose Big 90 0
• Cost of investment is 200 (all the firms cash)
• Required return is 50
• Expected CF from the Gamble 1000 0.10 0
  100

NPV 133
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Selfish Stockholders Accept Negative NPV Project
with Large Risks

• Expected CF from the Gamble
• To Bondholders 300 0.10 0 30
• To Stockholders (1000 300) 0.10 0
  70
• PV of Bonds Without the Gamble 200
• PV of Stocks Without the Gamble 0
• PV of Bonds With the Gamble
• PV of Stocks With the Gamble
• The value of firm becomes 67 20 47 200 -
  133

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Selfish Strategy 2 Underinvestment

• Consider a government-sponsored project that
  guarantees 350 in one period
• Cost of investment is 300 (the firm only has
  200 now) so the stockholders will have to supply
  an additional 100 to finance the project
• Required return is 10

NPV 18.18
Should we accept or reject?
8
Selfish Stockholders ForegoPositive NPV Project

• Expected CF from the government sponsored
  project
• To Bondholder 300
• To Stockholder (350 300) 50
• PV of Bonds Without the Project 200
• PV of Stocks Without the Project 0
• The value of firm 272.73 54.55 218.18200
  18.18

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Selfish Strategy 3 Milking the Property

• Liquidating dividends
• Suppose our firm paid out a 200 dividend to the
  shareholders. This leaves the firm insolvent,
  with nothing for the bondholders, but plenty for
  the former shareholders.
• Such tactics often violate bond indentures.
• Increase perquisites to shareholders and/or
  management

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Integration of Tax Effects and Financial Distress
Costs

• There is a trade-off between the tax advantage of
  debt and the costs of financial distress.
• It is difficult to express this with a precise
  and rigorous formula.

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Integration of Tax Effectsand Financial Distress
Costs
Value of firm (V)
Value of firm underMM with corporatetaxes and
debt
Present value of taxshield on debt
VL VU TCB
Present value offinancial distress costs
Maximumfirm value

V Actual value of firm
VU Value of firm with no debt
0
Debt (B)
Optimal amount of debt
B
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Signaling

• The firms capital structure is optimized where
  the marginal subsidy to debt equals the marginal
  cost.
• Investors view debt as a signal of firm value.
• Firms with low anticipated profits will take on a
  low level of debt.
• Firms with high anticipated profits will take on
  high levels of debt.
• A manager that takes on more debt than is optimal
  in order to fool investors will pay the cost in
  the long run.

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Shirking, Perquisites, and Bad Investments The
Agency Cost of Equity

• An individual will work harder for a firm if he
  is one of the owners than if he is one of the
  hired help.
• While managers may have motive to partake in
  perquisites, they also need opportunity. Free
  cash flow provides this opportunity.
• The free cash flow hypothesis says that an
  increase in dividends should benefit the
  stockholders by reducing the ability of managers
  to pursue wasteful activities.
• The free cash flow hypothesis also argues that an
  increase in debt will reduce the ability of
  managers to pursue wasteful activities more
  effectively than dividend increases.
• The managers may decide to pursue a capital
  structure which is less levered than that implied
  by maximized value, trying to reduce the risk in
  bankruptcy, thus the risk in losing his own job.

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The Pecking-Order Theory

• Theory stating that firms prefer to issue debt
  rather than equity if internal finance is
  insufficient.
• Rule 1
• Use internal financing first.
• Rule 2
• Issue debt next, equity last.
• The pecking-order Theory is at odds with the
  trade-off theory
• There is no target D/E ratio.
• Profitable firms use less debt.
• Companies like financial slack

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Growth and the Debt-Equity Ratio

• High growth firms face high operating risk so
  they adopt less risky financial strategy.
• Growth implies significant equity financing, even
  in a world with low bankruptcy costs.
• Thus, high-growth firms will have lower debt
  ratios than low-growth firms.
• Growth is an essential feature of the real world
  as a result, 100 debt financing is sub-optimal.

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Capital Structure and Operating Risk

• Operating risk a firms facing uncertainty in
  product prices, variable and fixed costs. This
  risk does not involves with debt financing. We
  can measure operating risk by standard deviation
  of operating income, i.e. EBIT.
• Financial risk a firm facing uncertainty
  resulted from debt financing. Using debt
  increases uncertainty in EPS (and ROE).

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Analysis on Operating risk(Break-even Analysis)
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Break-even Analysis

• One firm could have two ways to produce the same
  product. The first is to employ 20,000 fixed
  cost and thus incurs 1.50 variable cost per
  unit. The second is to employ 60,000 fixed cost
  and incurs 1.00 variable cost per unit. What
  are the break-even volume for each production
  method? On what level of production volume that
  both ways will produce the same level of EBIT?
  The price for the product is 2.00.

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The first method
The second method
On what level of production volume that both ways
will produce the same level of EBIT?
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EBIT
1st 2nd
40,000 60,000 80,000 Sales/Quantity
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Financial Break-even Analysis

• A firm currently has 2,000,000 bond
  outstanding, which has 8 coupon rate, in
  addition to its 100,000 shares common stock. The
  firm is consider to undertake 1,000,000
  expansion plan, which could be financed by either
  of two alternatives
• (1)100 debt financed which is issued on par and
  10 coupon rate
• (2)100 equity financed with issuance of new
  stock, and at a price of 10.
• The firm expects its operating income (EBIT) to
  be 800,000, and corporate income tax rate is
  25. What will be the financial break-even
  points for both alternatives? What will be the
  EBIT/EPS indifferent point? Which financing
  alternative leads to higher EPS if the expected
  EBIT is 800,000?

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EPS
Alt 1
Alt 2
EBIT
160,000 260,000
360,000 800,000
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Degree of Operating Leverage
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Degree of Financial Leverage
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Degree of Combined Leverage DCL
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Integrate operating and financial risk with
financing alternatives

• Firms try to manage total risk (financial and
  operating) to an acceptable level.
• Firms with high operating risk, tend to adopt
  less financial risk financing (equity financing
  dominant) alternatives, to avoid high interest
  payment.
• Firms with low operating risk, tend to adopt more
  financial risk financing (debt financing
  dominant) alternatives, to increase ROE.